A microeconomic perspective on the cash-flow endogeneity in terminal value models

Abstract

Abstract This paper studies how treating free cash flow (FCF) as endogenous—shaped by a firm’s investment choices—changes terminal value calculations. In practice, analysts address the uncertainty and ambiguity of the perpetual growth rate g and the cost of capital r with sensitivity tables or specific assumptions such as value-neutral net investments. The standard perpetual growth model takes perpetuity-phase FCF as exogenous, driven by a pre-specified g and unaffected by changes in r. Using a simple microeconomic framework with diminishing marginal returns, we show that shifts in g or r change the optimal scale of investments and thus future FCF. We incorporate these links into a perpetuity-phase model and identify three effects of cash-flow endogeneity: an optimization effect (investment scale rebalances), a delay effect (lagged project cash flows), and a transition effect (firm cash flow converges as legacy projects expire). Our results show that the conventional terminal value approach significantly overstates value sensitivity to g; in our example, recognizing cash-flow endogeneity narrows the terminal-value range by nearly 25% for a ± 2-percentage-point change in g. Changes in r generate offsetting effects on scale and timing, yielding small, slightly positive valuation differences. The effects are strongest for firms with long-lived assets or high output elasticity of capital input. This framework refines terminal value estimation by tying growth assumptions to investment behavior and cash-flow dynamics.